PE investments in Indian real estate have been growing rapidly. As of March 2019, SEBI data shows commitments towards Category II AIFs, which include real estate private equity funds, have touched $30bn. And yet, there is a curious dichotomy for investors: on the whole, the real estate industry is growing rapidly, and yet, many of their individual investments don’t seem to be paying off as well as expected.
What explains the overall growth and returns of the industry and the highly variable outcomes of specific investors? How are certain types of funds able to offer consistently high IRRs on all their projects, while others seem to have a wide variance from asset to asset? In this article we answer this question with three key insights, showing that it is not in fact the innate unpredictability of real estate, but instead controllable factors that a few firms have mastered while most are unable to.
Legal curation: Every institutional investor in real estate undertakes legal due diligence prior to investing funds. However, not all legal diligence is of the same quality. While all firms will engage the services of lawyers to vet the title documents and obtain a written title report, some go beyond just the documentation and delve deeper into the legal risks. They will have liaising departments that check with various government agencies about the liaising and regulatory risks that could be specific to that land parcel or the proposed project. They will check with local information sources about any disputes simmering beneath the surface that could be revealed during the development phase. They will use architects to evaluate the development plan to ensure that it complies with building codes and by-laws. We have done exactly that here at SmartOwner, for instance by recently discovering that what seemed like a highly desirable star project had a local issue that would have caused problems with its road access, thus potentially reducing returns through a protracted legal battle or, in the worst case, cancellation of the project.
Financial expertise: All institutional investors have highly trained investment teams with smart MBAs and finance professionals. These experts tend to be very good at crunching the numbers to see if a proposed investment will meet the investment objectives. But a spreadsheet is only as good as the numbers one plugs into it, and most funds are dependent on external sources, very often the proposed investee, for the project’s numbers. The more successful firms, on the other hand, have finance professionals who are complemented by in-house experts to ensure that key numbers, such as costs, timelines, sale price, and sales velocity, are taken at conservative values based on the specifications of the project and the prevailing conditions in the market.
Real estate expertise: The very biggest developers often do not offer very high IRRs to their funding sources as their brand allows them to wield significant bargaining power. With a large number of institutional sources of capital available, the returns from these projects tend to be average at best. The best IRR opportunities come from underrated regional or local developers who are excellent at a particular set of competencies but perhaps lacking in others. Institutional investors who have deep domain expertise in the various functional areas of real estate, such as architecture, engineering, project management, marketing and sales, are able to tap into these smaller developers and yet keep risks low as they are able to fill any void in competency that may exist with a particular developer. These additional services complement the skills of the developer and allow the project to be more successful and thereby offer higher returns. For instance at SmartOwner, we offer consulting services for architectural design, land-sourcing, project management and other critical tasks with our team of in-house experts, thus extracting higher IRRs for our clients.
Conclusion: There has never been a better time to invest in real estate. Strong macroeconomic indicators and local trends both point to a period of sustained growth over the next few years. Regulatory changes are making the industry more transparent, reducing project-risk, and improving the range of instruments available to best accelerate growth in the sector. As the returns from real estate outpace potential gains from other sectors, and demand continues to outstrip supply, the market is experiencing an increase in both the number of investable assets on offer as well as the number of investment firms like PE funds that are expanding into real estate. Unfortunately, the profits from real estate are not going to be democratic even as they continue to rise. Firms that are experts, with strong competence in the various aspects of the real estate industry, will be able to select the best deals, execute with the highest quality, and offer the most lucrative IRRs for clients.